Rising housing and stock markets aren’t producing a strong ‘wealth effect’ this time around

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Home prices in March shot up 10.9%, the largest gain in seven years, according to the latest read by the Standard & Poor’s Case-Shiller index. Rising home prices, though still off 28% for their 2006 levels, are once again starting to generate wealth for some homeowners. Meanwhile, the S&P 500 Index (SPX) and Dow Jones Industrial Average (INDU) are trading at near record highs, as well:

^SPX Chart

^SPX data by YCharts

The burning question for investors is whether a broader “wealth effect” from improving property prices and a robust equity market – which together boosted the broader economy in the middle of last decade – is making a comeback. According to the the wealth effect hypothesis, climbing prices for homes and equities increase general consumption because people feel wealthier and more optimistic about the future. The quick answer: Not as much as you might think.

According to the the wealth effect hypothesis, climbing prices for homes and equities increase general consumption because people feel wealthier and more optimistic about the future.

Let’s start with the housing sector. Before the property market bust that began in 2007, many U.S. consumers regularly used their homes as giant ATMs to finance their lifestyles. Some bought and quickly sold homes to pocket capital gains. Others took out home equity loans.

This time around the wealth effect from the housing rebound is likely to be more muted, according to a recent analysis by Bloomberg.

For one thing, the property market is still in a healing phase. Homeowner equity hit $8.2 trillion in the fourth quarter of 2012, a big improvement from the $6.2 trillion low recorded in the first quarter of 2009. Even so, that’s far off from the record $13.5 trillion at the housing bubble’s peak back in 2006, data compiled by Bloomberg show.

Though banks are easing up a bit on home equity loans, it’s still the case that only creditworthy consumers can get them or refinance their mortgages.

Regarding a broader wealth effect, things seem to be different this time around, according to a recent research paper (pdf) by Credit Suisse analysts Neal Soss and Henry Mo. According to Soss and Mo: “Wealth effects appear to have shrunk since the 2007-2008 financial crisis, and more so for housing wealth than stock market wealth.”

Using Fed data and other sources, Soss and Mo come with an “elasticity consumption estimate” that suggests that home price and stock market gains deliver less of a positive punch to consumer spending these days than back in 2007. Check out the chart below for details:

wealth effect

Photo Credit: Christopher Chan